Political Issues Torpedo EADS-BAE Merger

The collapse of merger talks between EADS and BAE Systems shows how much influence governments have on the European aerospace industry. It is making mergers all but impossible, even outside Europe.

The two companies called off their planned merger last week, just hours before the British Takeover Panel's deadline for further clarification expired. Executives had tried last-ditch efforts to save the deal, but it had become increasingly clear in the past few weeks that serious political reservations could not be overcome.

Observers suspect that the failed merger is a stark indication of the limits of change for the European aerospace industry. The disagreement among governments “indicate[s] how difficult, politically and financially, it is to win over the numerous stakeholders involved in such mergers,” notes Tom Cruszcz, a director at Fitch Ratings. He concludes that “such obstacles are likely to remain a permanent feature of the sector in light of its inherent security sensitivities,” and suggests there will be “little change to the make-up of the industry in Europe in the medium term.”

In other words, Boeing, Lockheed Martin, Northrop Grumman and their peers now know pretty well which European rivals they will have to deal with in the future: the same ones they are facing today.

Strategically, EADS will have to deal with a defense division that will remain weak in comparison with competitors for the foreseeable future. The company will continue to rely on Airbus as its main source of revenues and profits, but also risks. It has been looking at smaller acquisitions in the U.S., but success has been limited, and without the BAE Systems combination, it will not get anywhere near the size of the defense business it had hoped for.

There have been rumors that BAE Systems may now look for another merger partner. But BAE's CEO Ian King said that there are no plans for any other transaction and that no management changes are to be expected.

For differing reasons, it seems unlikely that any of the large U.S. aerospace groups would look at merging with BAE Systems. One concern they all have is that the British company's U.S. business is not for sale as a separate entity. Any investor would have to pick up the entire group, a very complex international transaction.

Additionally, Lockheed Martin appears to be focused on delivering on the F-35 program, rather than taking on the problems of integrating a large entity. Northrop Grumman has just divested several units, and whether other potential candidates—such as Boeing—would seek to increase their already sizeable exposure to the U.S. defense market appears doubtful.

Governments were not the only ones to question the merger's merits. Invesco Perpetual, an investment fund and BAE Systems' largest shareholder with a 13.3% stake, slammed the deal in a public statement timed roughly a day before the merger deadline. The fund wrote that it has “significant reservations regarding both the [merger] proposal and its long-term impact on value for BAE Systems' shareholders,” going on to say that it “does not understand the strategic logic for the proposed combination of EADS and BAE Systems.”

Invesco also argued that the deal would “materially jeopardize BAE's unique and privileged position in the United States defense market” and that it has been unable to identify any corresponding benefits to offset this risk.

EADS Chairman Arnaud Lagardere also said he was unhappy with the terms of the proposed transaction and wanted more concessions before agreeing to it.

The proposed merger announced four weeks ago would have created the world's largest aerospace group, with sales of around $100 billion, far surpassing the current market leader, Boeing. The combined entity would also have had a portfolio more balanced between civil and defense businesses.

According to sources close to the negotiations, the deal failed because the German government blocked it. Those sources note that it was difficult to even conduct negotiations and there was little agreement on key proposals, which included far-reaching job guarantees and an important role for Germany as the site for part of the combined entity's headquarters. Germany also would have been allowed to buy a stake of up to 9% in group.

“It is, of course, a pity we didn't succeed but I'm glad we tried,” EADS CEO Tom Enders says. In a letter to employees, Enders admits that “we never expected to face such opposition against the deal, in particular not in Berlin.” He adds that “we will need to review our group strategy and defense activities in particular.”

BAE's King says he was “obviously disappointed.” However, he adds that “our business remains strong and financially robust.” BAE Systems was not prepared to do anything that would have compromised its important U.S. business, he notes, indicating that concerns over government influence played a key role in the decision.

According to King, EADS and BAE Systems will not resume talks until the political landscape surrounding a possible deal has changed materially.

Both companies say it wasn't business logic that prevented the transaction. Instead, they say, “It has become clear that the interests of the parties' government stakeholders cannot be adequately reconciled with each other or with the objectives that BAE Systems and EADS established for the merger.”

Peter Hintze, the German aerospace coordinator, indirectly confirms the reservations of the German government: “I believe that in this formation [EADS and BAE Systems remaining separate] Germany's industrial policy interests to sustain a strong aerospace value chain from research to development and industrial production is served the best.” German Defense Minister Thomas de Maiziere, upon hearing EADS's comments that Germany was responsible for the breakdown, said: “I don't agree.”

U.K. Defense Minister Philip Hammond says the deal was “too difficult” to achieve when all different interests had to be taken into account.

French President Francois Hollande says governments should not be held responsible for the breakdown of the talks. “That is a decision made by the companies,” he says, noting that France would continue to support EADS. France and the U.K. appeared to have come closer to an agreement. Sources say France would have been prepared to limit its ownership in the company, a key prerequisite for the U.K.'s approval of the deal.

But now, EADS may be facing even stronger government influence than in the past. Recently, Daimler confirmed that it still plans to sell part of its stake in EADS to the German government by the end of the year. In France, a 7.5% stake held by the Lagardere Group is now for sale and with the merger off, the government is again free to pick it up.

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